November 22, 2009

How Does a Falling Dollar Impact You?

Massive spending, large fiscal deficits, and huge debt accumulation (currently $12 trillion, having doubled in past 8 years)…this is the story of our Government. Throw in a loose monetary policy and it is no wonder other countries continue to talk of moving off the dollar as the world’s chief currency reserve. This past week President Obama was in Asia and they have made it very clear they do not like a weak dollar.The Wall Street Journal recently had an excellent article which addressed the so called “Asian Asset Bubble” and “Carry Trade” which is being blamed on our easy money policy.

Much of the current concern involves the U.S. government’s debt-funded economic stimulus efforts that have flooded the economy with cash.This causes the dollar to fall in value when compared to other currencies.

Many are also concerned that China and other countries may cut back their purchases of U.S. government securities. Inflation and a weakened demand for U.S. debt/bonds would undermine the dollar, since bond demand equates to dollar demand.In addition, the Fed itself has been the biggest buyer of government bills, notes, and bonds during the past seven months as a result of the quantitative easing program it launched in March. In the second quarter of this year, for example, the Fed absorbed nearly half of all net Treasury issuance.

To attract investors who are less interested in those bonds and more worried about inflation, the government would theoretically have to pay higher interest rates. That could cause interest rates to rise for mortgages, car loans and other types of consumer and business debt.

The dollar is still the most used currency for international transactions and constitutes over 60% of other countries' official foreign-exchange reserves. But the reputation of our nation's money is being compromised.

The chart below shows the dollar index and its significant fall since 2000.It is interesting to note how at the beginning of this current recession the dollar surged.This is largely the result of other countries buying our currency as they were seeking safety that our country and our stable government provides (a flight to quality).Notice how once the world’s economy started to stabilize the dollar started falling.This also matches up with our monetary policy of pumping liquidity into the system.

A weaker dollar means it takes more dollars to exchange for a given block of foreign currency, such as Yuan, Yen or Euro... The weaker the currency, the cheaper its exports look overseas and increases the competitiveness of U.S. goods. A weaker dollar boosts foreign demand while keeping U.S. consumer demand domestic.Over the short term, this benefits the sales of U.S. corporations which will eventually translate into more jobs and consumer spending.It also helps to reduce the trade deficit. China and Japan kept their currencies artificially low for years to export their way to financial strength. With U.S. consumer demand weak, this may be the best way to get things moving. A weak dollar also pumps up our stock market and also helps to devalue away America’s rising debt burden.

We also have a huge inventory of unsold homes here in the United States. Another byproduct of a cheaper dollar would be inflation and an increase in real estate prices. Getting a bounce in the real estate market would reduce the number of homes under water.

Some disadvantages of a weak dollar would be higher costs for foreign goods.With a huge trade deficit, U.S. consumers import far more than they export.While this may make sense in theory, there are practical risks to devaluing your currency. Once the inflation genie gets out of the bottle, we may not be able to put it back in. People will be relatively poorer if assets go up more than their incomes do. Their house might not be worth more, but they still might have issues with things like food, gas…

If you were a foreign government, would you want to increase your holdings of Treasury securities knowing the U.S. government has no plans to balance its budget during the next decade, let alone achieve a surplus? In the European Union, countries wishing to adopt the Euro must first limit government debt to 60% of GDP. It's the reference point for demonstrating "soundness and sustainability of public finances." Politicians find it all too tempting to print money and excessive government borrowing poses a threat to monetary stability.The U.S. Government Debt as a percentage of GDP is projected to be over 100% by 2011 (this is using the CBO estimates).

The U.S. has long served as the world's financial leader and the dollar's primary role in the global economy has likewise seemed to testify to American strength. But our government’s current monetary policy is putting our future leadership role at risk and has the rest of the world questioning whether our money can be trusted.

This is why foreign bankers in countries that are large holders of dollars (like China and Russia) are talking of inventing a new global currency.It is why oil-producing countries in the Middle East want to move off the dollar for valuing oil.

It will be interesting to watch the Federal Reserve try to pull back on its quantitative easing policy and to see if Congress and the President are able to reduce deficits.The short term benefits of a weak dollar are obvious, but the long term consequences could be damage that cannot be undone.